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A Fantastic Buying Opportunity in Chinese Stocks Is on the Horizon

In this third part of our series examining major stock indices around the globe, we turn to China and the Shanghai Stock Exchange Composite Index (SHA:000001). We noted previously that the state of the Chinese economy influences world markets for raw materials, and in December we pointed out that copper prices would decline, partly in relation to developments in China. This month, we see continued signs that China's growth engine is encountering more drag. The Shanghai Stock Exchange, China's largest stock exchange and the sixth largest stock market in the world, is giving signs that we should expect it to decline for at least the next year, probably longer.

China's economic data are not severely gloomy, at least not yet. Several indicators of China's economic growth remain high relative to other nations, but they have shown a pattern recently of coming in below projections. For example, June data show that industrial production rose by 9.2% over a year ago, although it still fell short of expectations. Surveys of purchasing managers show that increases in manufacturing are slowing, and new export orders are actually declining. The service sector is faring somewhat better.

However, the yardstick is different for China. A growth rate that would seem high for another country actually is necessary in order for China to lift much of its population out of poverty and engage them in non-agricultural jobs and a production-consumption cycle. Faltering economic growth is likely to have a severe effect on stock markets.

Also alarming is the rapid growth in total lending, which has grown 65% since a year ago and now amounts to $1.3 trillion. In addition, China's total credit is almost twice its GDP. Meanwhile, the economic effectiveness of lending is declining. Five years ago, there was almost a 1 to 1 relationship between investment and increased economic output (e.g., one dollar of GDP growth for each dollar invested). Of late, credit effectiveness has declined markedly, approaching a 1 to 4 ratio. Lending is the Chinese government's favored method of encouraging economic growth, but this is likely to become more difficult in future months.

In the context of slowing growth and perhaps even contraction to be expected in some sectors, our technical analysis of China's premier stock market suggests that the composite index may decline over the next 12 to 18 months to as low as half its present value.

So far, the decline in the index since 2009 has been orderly, staying within a nicely defined channel. The move away from the 2009 high appears to be impulsive, which would be consistent with the third, or [c] wave of a correction from the 2008 high in Elliott Wave analysis. If so, the completion of [c] could mark the termination of the down-move, once the pattern is complete -- i.e., after price traces out the final wave (v) of [c]. When that time arrives, Chinese stocks will represent a fantastic buying opportunity.

A natural target for the declining index would be a test of the center line of the channel. Likely support levels along the way include 1210 and 1472. Confidence in this scenario will increase with a monthly close below the prior wave (iii) and also below the 1/4 channel line (dotted line) that has acted as support during the last two years.

Unfortunately for the trader, there is no easy way of shorting the index. China has only recently begun allowing a small number of stocks to be sold short, and there is no inverse ETF for the entire composite index. While there is at least one short ETF for select companies listed on the Hong Kong exchange (ProShares Short FTSE Xinhua China 25 (YXI)), one shouldn't count on Hong Kong following the same path as Shanghai. However, a patient investor should see a remarkable buying opportunity on the horizon.